FOMC preview – please hike, but be careful going forward

Summary:
The Federal Reserve is widely expected to hike the Fed funds target rate by 25bp today. The real question is how much more the Fed will deliver going forward.
To get an idea about we are happy to give you a sneak preview on the “country page” for the US monetary policy from our soon to be launched Global Monetary Conditions Monitor (GMCM).
See here (in PDF here):
Just to explain what we are doing in GMCM we do not try to forecast what central bankers will do, but rather we assess or measure monetary conditions. This is a lot less straight forward than people often think. For example the actually level of the key policy rate – in the case of the Fed the Fed funds target rate – on its own says very little about the monetary stance.
Overall, the price level and nominal demand in the economy is determined by the interaction between the money supply and money demand.
It is the task of the central bank to use whatever instrument(s) it uses to to ensure that this interaction between money supply and money demand causes the target – for example inflation – to be hit.
Therefore our starting point in GMCM is to assess monetary conditions relative to the given central bank’s target. In the case of the Fed a 2% inflation target.

Just to explain what we are doing in GMCM we do not try to forecast what central bankers will do, but rather we assess or measure monetary conditions. This is a lot less straight forward than people often think. For example the actually level of the key policy rate – in the case of the Fed the Fed funds target rate – on its own says very little about the monetary stance.

Overall, the price level and nominal demand in the economy is determined by the interaction between the money supply and money demand.

It is the task of the central bank to use whatever instrument(s) it uses to to ensure that this interaction between money supply and money demand causes the target – for example inflation – to be hit.

Therefore our starting point in GMCM is to assess monetary conditions relative to the given central bank’s target. In the case of the Fed a 2% inflation target.

Said in another way in our composite indicator for monetary conditions a zero “score” indicates that the Fed will hit its 2% inflation target in the medium-term (2-3 years). If the score is above (below) the then it indicates that the central bank will overshoot (undershoot) its inflation target.

Similar we say that monetary policy is too easy (tight) if the composite indicator is above (below) zero.

The composite indicator is a weighted average of four sub-indicators – broad money supply growth (in the case of the US Divisia M4-), nominal demand growth (often nominal GDP, but in the case of the US Private Consumption Expenditure growth), exchange rate developments and finally the key policy rate (the Fed funds target rate in the US).

For all of these sub-indicators we calculate a growth rate or level, which we believe is what we call “policy-consistent” meaning the growth rate of for example broad money supply growth, which is necessary to hit the central bank’s inflation target.

In the case of the US we see that broad money supply growth (here measured as Divisia M4- growth) presently is more or less in line with the policy-consistent growth rate meaning that looking at money supply growth along we should expect the Fed to hit it’s 2% inflation target in the medium-term.

For the money supply we calculate the policy-consistent growth rate based on the Equation of Exchange (in growth rates):

(1) m + v = p + y

Where m is the growth rate of the broad money supply, v is money-velocity growth, p is inflation and y is real GDP growth

We can re-arrange that:

(1)’ m-target = p-target + y* – v*

m-target is our policy-consistent growth rate for broad money growth, p-inflation is the inflation target (in the case of the US 2%), y* is the strutural trend in real GDP growth and v* is the structural trend in money-velocity. We generally use HP-filters to estimate y* and v*.

In the graph broad money supply growth on the US “country page” the dark green line is actually broad money supply growth and the light green line is m-target (the policy-consistent growth of m).

The difference between the two is essentially a measure of the monetary stance. This is the bars in the graph. Taking into account that monetary policy works with “long and variable lags” we take an 3-year weighted moving average of this gap. That is also the input into the composite indicator.

We use the same kind of method for the three other sub-indicators.

In the case of the US we see that money supply growth and nominal demand growth are pretty much in line with the policy-consistent growth rates, while the rate of appreciation of the dollar is (or rather has been) slightly too fast and the interest rate level is slightly too high.

Overall, we see that the composite indicator for the US is quite close to zero, but still below. This indicates that US monetary conditions are what we term “broadly neutral”, but also that inflation risks in the medium-term are twisted slightly to the downside relative to Fed’s 2% inflation target.

We also see this from our inflation forecast graph. The inflation “forecast” is essentially a simulation of the most likely path for inflation given the present monetary stance (not to be confused with Fed’s key policy rate) and the recent trends in inflation.

We see that the forecast is for US inflation to continue to inch up, but it will not quite get to 2%. This is pretty much also what for example TIPS breakeven inflation expectations show.

What does this mean for market pricing?

When assessing the overall monetary stance it is always very important to remember that we have to look at for example interest rates or the exchange rate relative to expectations. Hence, a 25bp interest rate hike today from the Fed in itself is not monetary tightening is it is completely priced in already.

Therefore, if we want to assess future monetary developments in the US we need to look at market pricing.

Overall the markets are presently pricing in somewhere between two and three 25bp hikes from the Fed this year – including the hike expected for today.

The purpose of our framework in Global Monetary Conditions Monitor is not to forecast how many rate hikes the Fed will deliver this year. But it can tell us about the consequences of difference paths for interest rates.

Hence, one can say that since our composite indicator for US monetary conditions indicates that the Fed is likely to slightly undershoot its 2% inflation target then it would be better for the Fed to deliver a little be less in terms of rate hikes than is presently priced by the markets.

This is not a forecast as central banks often do things they shouldn’t – if they didn’t it would be very easy to forecast their actions – but it nonetheless tells us something about the potential risks relative to market pricing if we assume that the Fed at least in he end will end up doing the right thing.

Looking for reviewers

We are looking forward to publishing Global Monetary Conditions Monitor very soon, but we are also still looking for input. So we are looking for “reviewers” of what we call the country pages of the 25 countries covered in GMCM.

So if you are interested in getting a sneak preview on parts of the GMCM in return for comments please let us know. Mail [email protected] or [email protected] We prefer policy makers/central bankers and market participants, but don’t be shy to drop us a mail.

Lars Christensen is an internationally renowned Danish economist specialised in international economy, Emerging Markets and monetary policy. Lars has over 20 years’ experience in government and banking and is the founder and owner of Markets and Money Advisory and is a Senior Fellow at London’s Adam Smith Institute.